Testing Daily-Rolled EURUSD Butterfly Option Returns

Summary

The document describes a daily-rolled backtest of EURUSD options using one-month and two-month straddles, 25-delta risk reversals, and 25-delta butterflies. Each position is held for one trading day, with the next day's valuation using the full volatility term structure to account for volatility roll-down. The reported straddle and risk-reversal returns appear relatively well behaved, while long butterflies show very poor Sharpe ratios and short butterflies appear unusually smooth and profitable.

The author contrasts this result with S&P options, where shorting butterflies performs poorly, and asks whether EURUSD convexity might be persistently overpriced and why. The document offers no explanation or evidence to establish that conclusion. It flags the key limitation: daily rolling would incur prohibitive transaction costs, so the apparent backtest performance may not translate into a tradable strategy; a more realistic holding or rolling schedule remains unresolved.

Key ideas

• The backtest holds each option structure for one trading day and includes volatility term-structure roll-down in the next-day valuation.
• Long EURUSD butterflies show sharply negative reported Sharpe ratios for the shortest tenors examined.
• Shorting the butterflies appears unusually profitable in the reported backtest, unlike the comparison with S&P options.
• Prohibitive transaction costs from daily rolling make the apparent returns difficult to trade.
• The document poses, but does not answer, whether EURUSD convexity is overpriced or why.

Tags

# FX options: is convexity usually heavily overpriced?


# FX options: is convexity usually heavily overpriced?












I have access to daily vol quotes for EURUSD options from 2006 to today. I was playing around with them and constructed a "daily rolled backtest" for various options constructs, like straddle, 25 delta risk reversal and 25 delta butterfly. This means I am buying, say a 1M straddle today, hold it for one trading day and my pnl would be the difference between today's and tomorrow s price. I am using the full term structure to price the options one day later, so I am considering the vol roll down. When I do this, the pnl series for straddle and risk reversal are fairly well behaved but for butterfly I get some crazy sharpes of about -5 or less for the 1M and 2M tenors. Shorting the butterfly gives me almost a straight line up in the backtest, which looks very weird. This would mean that FX convexity is heavily overpriced. If I compare this to S&P for example, things look very different. Shorting the butterflies performs rather poorly there. I am aware that this strategy I am looking at here is not tradable since the transaction costs of daily rolling are prohibitive, but can this be true? If I can find a more realistic way of rolling, I could probably still get a very profitable strategy? If convexity in EURUSD is really so heavily overpriced compared to other underlying, what is the reason?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.